Angels and Early Exits: Sometimes, a Bird in the Bush is Worth More than a Bird in the Hand
When high impact startups outside the major venture capital centers start getting on the radar screens of larger established venture center investors, their angel investors will from time to time be faced with a choice: should they cash out (sell their angel shares into the new VC round) or hold on to those shares in anticipation of a much bigger exit down the road. This is, as problems go, a pretty good one to have. That said, it is still a problem, and one that many angels find vexing. Herewith, some thoughts for angels struggling with this “high quality” problem.
To put some “real world” parameters around the problem, let’s posit that our angel invested $250k in the angel round at $0.25 share, as part of a broader investment strategy envisioning investing an aggregate of $2.5 million of capital in ten seed/early stage portfolio companies. One year later, a traditional, Silicon Valley based venture fund comes along and offers a $5 million investment at $1.00 per share – and offers to buy the angel’s shares for $1.00 each as well. Let’s assume that our angel has no particular insight on the future success of the company, beyond that a quality early stage venture investor is injecting $5 million at $1.00 share (which by itself suggests said investor expects to cash out at something likely north of $5.00 share). Query: should the angel, given the opportunity to sell its shares at $1.00 each, cash in or hold on?
Tempting as a quick 4x return might be, if you understand the rules of the road for high risk angel investing and you want your decision to reflect that understanding, the better decision is most likely to hold on to your shares.
To understand why holding is the “right” answer, recall one of the cardinal rules of venture investing: it is a portfolio game. That is, early stage investing most often rewards folks who invest in a portfolio of deals (ten per “fund” is a typical number, and the one we will use in this example). No doubt there are folks who make money limiting their angel bets to one deal – but those folks are better thought of as lucky gamblers than rational investors.
The portfolio model of seed/early stage investing is driven by the fact that solid performance across the portfolio – say a 3x-4x cash on cash return of the total investment in the portfolio – is driven primarily by the number of “home runs” in the portfolio, loosely defined as the number of investments that return 10x or more cash-on-cash returns. That’s because seed/early stage investing being what it is (very risky) a portfolio of ten investments will likely include several dogs (no return); several zombies (+/-1x return); several hits (2x-5x returns) and (hopefully) a couple of home runs (10x+ returns). If you want to see how this plays out in a spreadsheet model, click here. The bottom line is that achieving good portfolio performance is almost always about maximizing the number of 10x+ returns in the portfolio.
Which means that every company in the portfolio, when the investment therein is first made, has to have 10x+ potential. A seed/early stage investor simply cannot, given the inherently risky nature of such investing, afford to invest money in deals that don’t have 10x+ potential, as deals that don’t have such potential simply don’t, even if they “work,” have much impact on portfolio performance. (If you don’t like that kind of model, consider investing in later stage – i.e. less risky – deals.)
Ok, back to our example. The choices are cash out for a 4x return, or hold on – hoping for a 10x+ return (note that the later stage investor, taking less risk, is only looking for a 5x return, the achievement of which would result in a 20x return for our angel, assuming she holds on to her shares until the “real” exit). It seems, in light of our digression into portfolio theory, that the fairly obvious answer is to hold on to the shares. Why? Because cashing out for 4x would amount to liquidating an investment that more than ever (that is more than when it was first made) has portfolio-moving 10x+ potential for portfolio-marginal 4x returns. Such a trade would suggest either an investor who didn’t really understand the rules of seed/early stage investing or, if she did, lacked the courage of her convictions.
I am not saying that no rational early stage angel would, in the posited case, ever choose to cash out early for a 4x return. In the instant case, there could be additional factors (the age of the angel’s fund; the returns of the other deals in the angel’s fund; the angel’s dry powder vs. projected future needs for the deal in question if the terms of the deal would punish the angel for not investing in the current or future round; the angel’s “inside” insights on the future prospects of the company; etc.) that might change the analysis and result. But the broader lesson is pretty clear: absent some special factor/knowledge about a particular deal, when it comes to angels and early sub-10x exits, a bird in the bush is usually worth more than a bird in the hand.